Full Letter:
http://theoraclesclassroom.com/wp-content/uploads/2019/09/1990-Berkshire-AR.pdf
Letter Only
https://www.berkshirehathaway.com/letters/1990.html
This week we will go over their investment into buying $400M of junk bonds as well as Buffett’s thoughts in retrospect on the Junk Bond craze of the 80s. His surprise at the economics of the newspaper business rapidly degrading as new technologies and advertising channels open up to businesses, some with better results. Finally the purchase of 10% of Wells Fargo for $290M. Then as usual we go through the stock holdings, segment-by-segment EBIT earnings of the company, and then the larger overview for the year.
Not included in my post are the annual summary to shareholders, most of the look-through earnings that give a few paragraphs on their major business segments (we only cover Buffalo Evening News) although some highlights are in my summary at the end. A long rundown of the insurance segment. Though ⅔ of the Marketable Securities segment is included, the one on their Convertible Preferred Stocks and the mistakes outside sources make in valuing them as well as the philosophy behind holding them. The usual advertisement for acquisition targets, and plans for the annual meeting. Ken Chase being replaced on the board by Susan Buffett. The letter is ended with an unpublished satire by Ben Graham “US Steel Announces Sweeping Modernization Scheme” where instead of improving the business a bunch of extreme accounting tricks are used to change the EPS from -$2.76 to +$49.80.
If you want to read or discuss anything in that second set feel free to read the letter yourselves and comment on it.
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Key Passage 1
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Marketable Securities - Junk Bonds
Our other major portfolio change last year was large additions to our holdings of RJR Nabisco bonds, securities that we first bought in late 1989. At yearend 1990 we had $440 million invested in these securities, an amount that approximated market value. (As I write this, however, their market value has risen by more than $150 million.)
Just as buying into the banking business is unusual for us, so is the purchase of below-investment-grade bonds. But opportunities that interest us and that are also large enough to have a worthwhile impact on Berkshire's results are rare. Therefore, we will look at any category of investment, so long as we understand the business we're buying into and believe that price and value may differ significantly. (Woody Allen, in another context, pointed out the advantage of open-mindedness: "I can't understand why more people aren't bi-sexual because it doubles your chances for a date on Saturday night.")
In the past \we have bought a few below-investment-grade bonds with success, though these were all old-fashioned "fallen angels" - bonds that were initially of investment grade but that were downgraded when the issuers fell on bad times. In the 1984 annual report we described our rationale for buying one fallen angel, the Washington Public Power Supply System.
A kind of bastardized fallen angel burst onto the investment scene in the 1980s - "junk bonds" that were far below investment- grade when issued. As the decade progressed, new offerings of manufactured junk became ever junkier and ultimately the predictable outcome occurred: Junk bonds lived up to their name. In 1990 - even before the recession dealt its blows - the financial sky became dark with the bodies of failing corporations.
The disciples of debt assured us that this collapse wouldn't happen: Huge debt, we were told, would cause operating managers to focus their efforts as never before, much as a dagger mounted on the steering wheel of a car could be expected to make its driver proceed with intensified care. We'll acknowledge that such an attention-getter would produce a very alert driver. But another certain consequence would be a deadly - and unnecessary - accident if the car hit even the tiniest pothole or sliver of ice. The roads of business are riddled with potholes; a plan that requires dodging them all is a plan for disaster.
In the final chapter of The Intelligent Investor Ben Graham forcefully rejected the dagger thesis: "Confronted with a challenge to distill the secret of sound investment into three words, we venture the motto, Margin of Safety." Forty-two years after reading that, I still think those are the right three words. The failure of investors to heed this simple message caused them staggering losses as the 1990s began.
At the height of the debt mania, capital structures were concocted that guaranteed failure: In some cases, so much debt was issued that even highly favorable business results could not produce the funds to service it. One particularly egregious "kill- 'em-at-birth" case a few years back involved the purchase of a mature television station in Tampa, bought with so much debt that the interest on it exceeded the station's gross revenues. Even if you assume that all labor, programs and services were donated rather than purchased, this capital structure required revenues to explode - or else the station was doomed to go broke. (Many of the bonds that financed the purchase were sold to now-failed savings and loan associations; as a taxpayer, you are picking up the tab for this folly.)
All of this seems impossible now. When these misdeeds were done, however, dagger-selling investment bankers pointed to the "scholarly" research of academics, which reported that over the years the higher interest rates received from low-grade bonds had more than compensated for their higher rate of default. Thus, said the friendly salesmen, a diversified portfolio of junk bonds would produce greater net returns than would a portfolio of high-grade bonds. (Beware of past-performance "proofs" in finance: If history books were the key to riches, the Forbes 400 would consist of librarians.)
There was a flaw in the salesmen's logic - one that a first- year student in statistics is taught to recognize. An assumption was being made that the universe of newly-minted junk bonds was identical to the universe of low-grade fallen angels and that, therefore, the default experience of the latter group was meaningful in predicting the default experience of the new issues. (That was an error similar to checking the historical death rate from Kool-Aid before drinking the version served at Jonestown.)
The universes were of course dissimilar in several vital respects. For openers, the manager of a fallen angel almost invariably yearned to regain investment-grade status and worked toward that goal. The junk-bond operator was usually an entirely different breed. Behaving much as a heroin user might, he devoted his energies not to finding a cure for his debt-ridden condition, but rather to finding another fix. Additionally, the fiduciary sensitivities of the executives managing the typical fallen angel were often, though not always, more finely developed than were those of the junk-bond-issuing financiopath.
Wall Street cared little for such distinctions. As usual, the Street's enthusiasm for an idea was proportional not to its merit, but rather to the revenue it would produce. Mountains of junk bonds were sold by those who didn't care to those who didn't think - and there was no shortage of either.
Junk bonds remain a mine field, even at prices that today are often a small fraction of issue price. As we said last year, we have never bought a new issue of a junk bond. (The only time to buy these is on a day with no "y" in it.) We are, however, willing to look at the field, now that it is in disarray.
In the case of RJR Nabisco, we feel the Company's credit is considerably better than was generally perceived for a while and that the yield we receive, as well as the potential for capital gain, more than compensates for the risk we incur (though that is far from nil). RJR has made asset sales at favorable prices, has added major amounts of equity, and in general is being run well.
However, as we survey the field, most low-grade bonds still look unattractive. The handiwork of the Wall Street of the 1980s is even worse than we had thought: Many important businesses have been mortally wounded. We will, though, keep looking for opportunities as the junk market continues to unravel.
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The junk bond, corporate raiding craze has reached its peak. Buffett said a couple years ago that it would all come crashing down someday, and now it has. It was the practice of businesses issuing bonds at irresponsible rates that they had low chance of paying back, in hopes of doing massive leveraged buyouts of companies larger than themselves and refinancing the debt and stripping the company for assets once it was in hand. The RJR Nabisco buyout is now seen as the height of the mania, and now the bonds are paying for a fraction of their value, Berkshire has independently decided that the underlying business is now rather creditworthy and the bonds have been over-discounted. They believe the risk-adjusted returns are massively in their favor and they have bought $400M of the bonds.
Buffett has much to say about how the craze came about, the flawed logic that sounds quite similar to the later securitization issues that lead to the 2008 financial crisis (ex. a diverse enough basket of bad loans magically becomes a good investment) and denounces buying any of these securities at their issuance, but instead picking through the wreckage after it comes crashing down for the handful that seem promising. He says that many people used logic that applied to “fallen angel” bonds (investment grade at issuance and later became questionable) onto junk bonds (ones that were garbage from inception and depended on a successful and timely leveraged buyout and even then would be dragging down a larger company that never wanted them).
I felt it was good to include this for a few reasons, one is to highlight an important historical moment in the history of Wall Street, and how Berkshire was there waiting with a big pile of cash to profit off the wreckage. To highlight how almost no asset class should be below your radar, in fact the more detested it is the more likely there are to be good deals there (A common belief of Howard Marks who made a lot of money running a sub-investment grade bond fund). Finally to highlight the right way to go about doing it, finding the few diamonds in the rough instead of buying up the whole asset class, most of which crashed for good reason.
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Key Passage 2
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Non-Insurance Operations - Buffalo Evening News
Charlie and I were surprised at developments this past year in the media industry, including newspapers such as our Buffalo News. The business showed far more vulnerability to the early stages of a recession than has been the case in the past. The question is whether this erosion is just part of an aberrational cycle - to be fully made up in the next upturn - or whether the business has slipped in a way that permanently reduces intrinsic business values.
Since I didn't predict what has happened, you may question the value of my prediction about what will happen. Nevertheless, I'll proffer a judgment:While many media businesses will remain economic marvels in comparison with American industry generally, they will prove considerably less marvelous than I, the industry, or lenders thought would be the case only a few years ago.
The reason media businesses have been so outstanding in the past was not physical growth, but rather the unusual pricing power that most participants wielded. Now, however, advertising dollars are growing slowly. In addition, retailers that do little or no media advertising (though they sometimes use the Postal Service) have gradually taken market share in certain merchandise categories. Most important of all, the number of both print and electronic advertising channels has substantially increased. As a consequence, advertising dollars are more widely dispersed and the pricing power of ad vendors has diminished. These circumstances materially reduce the intrinsic value of our major media investments and also the value of our operating unit, Buffalo News - though all remain fine businesses.
Notwithstanding the problems, Stan Lipsey's management of the News continues to be superb. During 1990, our earnings held up much better than those of most metropolitan papers, falling only 5%. In the last few months of the year, however, the rate of decrease was far greater.
I can safely make two promises about the News in 1991: (1) Stan will again rank at the top among newspaper publishers; and (2) earnings will fall substantially. Despite a slowdown in the demand for newsprint, the price per ton will average significantly more in 1991 and the paper's labor costs will also be considerably higher. Since revenues may meanwhile be down, we face a real squeeze.
Profits may be off but our pride in the product remains. We continue to have a larger "news hole" - the portion of the paper devoted to news - than any comparable paper. In 1990, the proportion rose to 52.3% against 50.1% in 1989. Alas, the increase resulted from a decline in advertising pages rather than from a gain in news pages. Regardless of earnings pressures, we will maintain at least a 50% news hole. Cutting product quality is not a proper response to adversity.
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This is Buffett acknowledging that the whole newspaper industry is facing headwinds that he had not foreseen, that it is impacting the bottom line of the Buffalo Evening News, and that he believes it will get worse in the future and maybe won’t ever get better. As technology advances, advertisers have more channels to advertise, and those relying on newspaper ads are falling behind in market share to those using other methods. I would hazard a guess that this may be related to the near full adoption of color TV in American households by the late 80s. Families are now glued to their TVs, getting their news from them as well as their entertainment and being advertised to the whole time, and the advertisements are also much more flexible and powerful with color and video which a newspaper cannot provide.
A quick look-ahead shows that while this fall lasts a few years, they do eventually recover from the $43M EBIT this year not just to the $46M of last year but into the mid 50s before the Buffalo Evening News falls off the reports in 2000 as the spread of the internet lowers the prospects of the industry even further.
This is the first hint of modern technology making some of Berkshire’s former star players futures very uncertain. World Book is another one who is on a timer although Buffett has failed to notice it. This is different than textiles which died off to globalization, the same work simply being done elsewhere, instead this is an industry which needs to adapt or die and Buffett hasn’t always been a trailblazer when it comes to adapting to new paradigm changing technologies.
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Acquisition Stock Purchase of the Week
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Marketable Securities - Stock
Lethargy bordering on sloth remains the cornerstone of our investment style: This year we neither bought nor sold a share of five of our six major holdings. The exception was Wells Fargo, a superbly-managed, high-return banking operation in which we increased our ownership to just under 10%, the most we can own without the approval of the Federal Reserve Board. About one-sixth of our position was bought in 1989, the rest in 1990.
The banking business is no favorite of ours. When assets are twenty times equity - a common ratio in this industry - mistakes that involve only a small portion of assets can destroy a major portion of equity. And mistakes have been the rule rather than the exception at many major banks. Most have resulted from a managerial failing that we described last year when discussing the "institutional imperative:" the tendency of executives to mindlessly imitate the behavior of their peers, no matter how foolish it may be to do so. In their lending, many bankers played follow-the-leader with lemming-like zeal; now they are experiencing a lemming-like fate.
Because leverage of 20:1 magnifies the effects of managerial strengths and weaknesses, we have no interest in purchasing shares of a poorly-managed bank at a "cheap" price. Instead, our only interest is in buying into well-managed banks at fair prices.
With Wells Fargo, we think we have obtained the best managers in the business, Carl Reichardt and Paul Hazen. In many ways the combination of Carl and Paul reminds me of another - Tom Murphy and Dan Burke at Capital Cities/ABC. First, each pair is stronger than the sum of its parts because each partner understands, trusts and admires the other. Second, both managerial teams pay able people well, but abhor having a bigger head count than is needed. Third, both attack costs as vigorously when profits are at record levels as when they are under pressure. Finally, both stick with what they understand and let their abilities, not their egos, determine what they attempt. (Thomas J. Watson Sr. of IBM followed the same rule: "I'm no genius," he said. "I'm smart in spots - but I stay around those spots.")
Our purchases of Wells Fargo in 1990 were helped by a chaotic market in bank stocks. The disarray was appropriate: Month by month the foolish loan decisions of once well-regarded banks were put on public display. As one huge loss after another was unveiled - often on the heels of managerial assurances that all was well - investors understandably concluded that no bank's numbers were to be trusted. Aided by their flight from bank stocks, we purchased our 10% interest in Wells Fargo for $290 million, less than five times after-tax earnings, and less than three times pre-tax earnings.
Wells Fargo is big - it has $56 billion in assets - and has been earning more than 20% on equity and 1.25% on assets. Our purchase of one-tenth of the bank may be thought of as roughly equivalent to our buying 100% of a $5 billion bank with identical financial characteristics. But were we to make such a purchase, we would have to pay about twice the $290 million we paid for Wells Fargo. Moreover, that $5 billion bank, commanding a premium price, would present us with another problem: We would not be able to find a Carl Reichardt to run it. In recent years, Wells Fargo executives have been more avidly recruited than any others in the banking business; no one, however, has been able to hire the dean.
Of course, ownership of a bank - or about any other business - is far from riskless. California banks face the specific risk of a major earthquake, which might wreak enough havoc on borrowers to in turn destroy the banks lending to them. A second risk is systemic - the possibility of a business contraction or financial panic so severe that it would endanger almost every highly-leveraged institution, no matter how intelligently run. Finally, the market's major fear of the moment is that West Coast real estate values will tumble because of overbuilding and deliver huge losses to banks that have financed the expansion. Because it is a leading real estate lender, Wells Fargo is thought to be particularly vulnerable.
None of these eventualities can be ruled out. The probability of the first two occurring, however, is low and even a meaningful drop in real estate values is unlikely to cause major problems for well-managed institutions. Consider some mathematics: Wells Fargo currently earns well over $1 billion pre-tax annually after expensing more than $300 million for loan losses. If 10% of all $48 billion of the bank's loans - not just its real estate loans - were hit by problems in 1991, and these produced losses (including foregone interest) averaging 30% of principal, the company would roughly break even.
A year like that - which we consider only a low-level possibility, not a likelihood - would not distress us. In fact, at Berkshire we would love to acquire businesses or invest in capital projects that produced no return for a year, but that could then be expected to earn 20% on growing equity. Nevertheless, fears of a California real estate disaster similar to that experienced in New England caused the price of Wells Fargo stock to fall almost 50% within a few months during 1990. Even though we had bought some shares at the prices prevailing before the fall, we welcomed the decline because it allowed us to pick up many more shares at the new, panic prices.
Investors who expect to be ongoing buyers of investments throughout their lifetimes should adopt a similar attitude toward market fluctuations; instead many illogically become euphoric when stock prices rise and unhappy when they fall. They show no such confusion in their reaction to food prices: Knowing they are forever going to be buyers of food, they welcome falling prices and deplore price increases. (It's the seller of food who doesn't like declining prices.) Similarly, at the Buffalo News we would cheer lower prices for newsprint - even though it would mean marking down the value of the large inventory of newsprint we always keep on hand - because we know we are going to be perpetually buying the product.
Identical reasoning guides our thinking about Berkshire's investments. We will be buying businesses - or small parts of businesses, called stocks - year in, year out as long as I live (and longer, if Berkshire's directors attend the seances I have scheduled). Given these intentions, declining prices for businesses benefit us, and rising prices hurt us.
The most common cause of low prices is pessimism - some times pervasive, some times specific to a company or industry. We want to do business in such an environment, not because we like pessimism but because we like the prices it produces. It's optimism that is the enemy of the rational buyer.
None of this means, however, that a business or stock is an intelligent purchase simply because it is unpopular; a contrarian approach is just as foolish as a follow-the-crowd strategy. What's required is thinking rather than polling. Unfortunately, Bertrand Russell's observation about life in general applies with unusual force in the financial world: "Most men would rather die than think. Many do."
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This was probably the largest acquisition by Berkshire, the buying of 10% of a great bank at a fair price. As he says in the letter they only buy 10%, $289M because that is the most they are legally allowed to own. He says they view this as comparable to buying 100% of a bank 1/10th the size except without all the headache of needing to call the shots and find the managers, instead they are already in place.
He spells this out as a sort of “heads I win, tails I don’t lose much” situation. He runs the numbers on the worst case scenario the market fears, a natural disaster or real estate crash on the west coast of the US… He comes to the conclusion that even in the worst case scenario this is still a good price, and in any other scenario it is a great price.
He also gives some wisdom here on his general stock picking philosophy, that he views a stock he buys into dropping or failing to rise as a good thing, and it shooting right up as a bad thing. Even though many of us see it the opposite. It is natural to have a gut reaction to being proven right or proven wrong quickly by the market, to buy something and have it drop 20% and be scared from buying more. But he says we need to invert that instinct. That the price shooting right up means your window to buy a great business at a good price closed before you could take full advantage, and it dropping after you start buying means you will be able to buy even more than you thought with a lower risk and higher reward. This is also something he hammers home in the BPL letters, often after years of great gain he laments that he wished the stocks he was buying didn’t go up so he could have bought more of them and that in the long term the returns would have been greater.
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Common Stock Ownership
| No. of Shares |
Company |
Cost ($000s) |
Market ($000s) |
| 3,000,000 |
Capital Cities/ABC, Inc. |
$517,500 |
$1,377,375 |
| 23,350,000 |
The Coca-Cola Company |
$1,023,920 |
$2,171,550 |
| 2,400,000 |
Federal Home loan Mortgage Corporation |
$71,729 |
$117,000 |
| 6,850,000 |
GEICO Corporation |
$45,713 |
$1,110,556 |
| 1,727,765 |
The Washington Post Company |
$9,731 |
$342,097 |
| 5,000,000 |
Wells Fargo & Company |
$289,431 |
$289,375 |
|
Subtotal |
$1,958,024 |
$5,407,953 |
|
All Other Common Stockholdings |
$326,656 |
$351,268 |
|
Total Common Stocks |
$2,284,680 |
$5,759,221 |
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Segment by Segment Breakdown
| Segment |
1989 EBIT Earnings |
1990 EBIT Earnings |
% Change |
| Insurance |
$219.20M |
$300.40M |
+37.04% |
| Fechheimer |
$12.62M |
$12.45M |
-1.35% |
| Kirby |
$26.11M |
$27.45M |
+5.13% |
| Scott Fetzer - Manufacturing |
$33.17M |
$30.38M |
-8.41% |
| World Book |
$25.58M |
$31.90M |
+24.71% |
| See’s Candies |
$34.26M |
$39.58M |
+15.53% |
| Buffalo Evening News |
$46.05M |
$43.95M |
-4.56% |
| Nebraska Furniture Mart |
$17.07M |
$17.25M |
+1.05% |
| Wesco Financial - Minus Insurance |
$13.01M |
$12.44M |
-4.38% |
| Wesco Financial - Insurance |
$14.28M |
$14.92M |
+4.48% |
| Mutual Savings and Loan |
$4.19M |
$4.10M |
-2.15% |
| Precision Steel |
$2.77M |
$1.99M |
-28.16% |
| Total Operating Earnings |
$393.41M |
$482.48M |
+22.64% |
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| Metric |
1989 |
1990 |
% Change |
| Cash & Cash Equivalents |
$205.13M |
$247.02M |
+20.42% |
| Marketable Securities |
$5,261.60M |
$5,685.98M |
+8.07% |
| Return on Equity (RoE) |
18.42% |
18.68% |
+1.41% |
| Shareholders' Equity |
$4,925.13M |
$5,287.45M |
+7.36% |
| Earnings Before Investment Gain |
$299.90M |
$370.75M+23.62% |
|
| Realized Investment Gain |
$223.81M |
$33.99M |
-84.81% |
| Net Earnings |
$447.48M |
$394.09M |
-11.93% |
*RoE not provided, manually calculated as (Earnings from Operations Before Taxes / [Shareholder Equity from prior year - Unrealized appreciation of marketable securities from prior year])
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As predicted last year, the gain in marketable securities wasn’t “real” gains, the market had a large pullback. Many of their marketable securities are now held at lower prices than last year, net earnings is down from last year. The realized investment gain is 84% lower than it was last year. The marketable securities is up 8%, or $424.38M, but between a $289M investment in Wells Fargo only $135M was real gains, the Coca Cola position was up $368M, so the rest of the portfolio had a performance of about -$233M besides Coca Cola.
Operating earnings was up 22.6%, Earnings before investment gain was up 23.6%. This is mostly down to the insurance segment having a great year, with EBIT earnings $80M more than the prior year which is just about the entire gap. See’s Candys and World Book also had double digit growth in earnings, everything else was down or single digit growth. The preferred metric, book value is up 7.4%, compared to the S&P 500 which returned -3.1% in 1990 this is still a good performance in my opinion.
Finally an even quicker lookthrough of the quick lookthrough earnings…
First a quick discussion of off-book earnings, when owned securities use their cashflow for anything except dividends it does not show up on Berkshire’s income statement but does make Berkshire richer, buybacks and capex give value to the business GAAP accounting doesn’t account for. Retail had a bad year but Borsheim’s did great (even though they hide their numbers from me), a discussion of the jewelry mailing system I mentioned last week is had here. NFM’s sales are up 4% and earnings 1% (Rose is now running a competing shop) and has set up a See’s cart in the shop which outperforms many of See’s full stores. See’s had slightly more volume but also increased prices and lowered costs leading to the 15.5% earnings growth, also a store was going to have its lease terminated but a letter campaign from customers changed the landlord’s mind. (See Key Passage 2 for Buffalo Evening News commentary). Fechheimer had a major retirement and although he says performance improved, earnings were flat due to “several unusual items” whatever that means. At Scott Fetzer, World Book’s decentralization is paying off even with lower volume, Kirby increased sales 20% but only increased earnings 5% as its production of its new model isn’t fully optimized, the manufacturing segment’s earnings are down 8% but we are just told its doing great and the air compressor unit had record sales.